Q2 2017 Market Update


Good Times Continue

Happy summer to everyone! Hard to believe, but we are a mere month away from kids starting to return to school. I have heard it said before, the older you get the faster time flies and boy am I feeling this effect. Time keeps flying for the markets as well, with a continued slow and steady move upwards.

Through the first half of 2017, equities continue to deliver solid and steady gains with very little in the way of interruptions. The Wilshire 5000, Dow, S&P 500 and Nasdaq have been no more than about 3% off their 2017 highs at any point during the year. The Wilshire 5000 was up 7.70% for the year at quarter end and the Barclays Aggregate Bond market was up 2.45%. My expectation for some increased volatility in 2017 has yet to play out…. knock on wood. While it would be nice to see some more downside for rotating into opportunity, I am not going to complain about enjoying the steady returns.

The first quarter earnings season was a huge success. It needed to be a success given the higher valuations from the recent run up. This success certainly helped keep any declines away for the time being. According to the financial reporting system Fact Set, the S&P 500 delivered nearly 14% year-over-year company earnings growth, the highest growth rate since 2011. Analysts are again forecasting double-digit earnings growth in the second quarter. We remain cautiously optimistic anytime double-digit forecast are predicted. The higher the hurdle, the easier it is for markets to trip and fall. And the hurdle is starting to get a bit high.

The jobs situation looks solid. Total non-farm payrolls increased by 581,000 jobs in the quarter while the official unemployment rate closed the quarter at 4.4%. Wage growth, however, remains a disappointment, as a flood of new and available jobs hasn’t translated into higher incomes yet. We also are becoming more concerned at the number of retirees and experienced talent leaving the workforce which is reducing overall productivity. This is a longer term trend which we hope is quickly addressed through increasing use of technology such as AI (artificial intelligence) to bridge the gap and keep productivity moving forward. Unfortunately the adaptation of new technologies takes time and we will likely have some slowed productivity per worker before we see a large uptick. In this way we do not fear technology taking over and replacing jobs but actually need it sooner to compliment current jobs.

Events in Washington continue to remain a wildcard with major legislation not showing a clear picture just yet. Healthcare reform is front and center but the Senate’s version of “repeal and replace” doesn’t look like it has the necessary votes to pass unless several revisions are made. We have seen initial tax reform ideas but no concrete agenda just yet. Hopefully we get more clarity on these issues by year-end.

Long term equity and balanced (Equity and bond) investors continue to harvest solid gains relative to risk. Bringing us to the obvious question, what might we expect going forward?

Peak Under the Hood

We are cautiously optimistic about markets going forward. On one hand we are optimistic about the stability of banking, company risk and the current job market. On the other hand we acknowledge prices are pushing the upper end of historical valuations and it takes much less to send markets down in todays environment than in years past. With that said, offense is your best defense or the more annoying phrase, the trend is your friend.

Equity Valuation Thoughts:

Risk is correlated with the price of an asset. Give me a stock for free and I have very little risk. Said a different way, the chance for permanent loss increases as the asset gets more expensive. This goes against human nature, we see historically the chance for loss was likely lower in March of 2009 with a PE multiple on three year average earnings of about 9 for the S&P 500 compared with the PE in June of 2017. Today the same metric is over 19. Meaning we are paying 2.10 times more for each dollar of earnings as compared to 2009. While 2009 was clearly a deal, the price as a whole today is clearly not as attractive.

Paying higher multiples for businesses and receiving lower income yields or cash flow yields for companies naturally result in reduced convictions for stocks. Of course, with rates so low, we have learned to accept lower income, cash flows as part of the current reality we live. However, combination of solid corporate management, company innovation and Fed policies have all helped push stocks higher the past 4 years and could continue to push many equities higher over the near term. This is a good example of why we do not market time but prefer proper long-term balance relative to risk.

Bond Valuation:

Despite knowing that bonds are fully valued and perhaps overvalued, we don’t avoid them entirely, although we do remain underweight even for moderate clients. The reason we maintain exposure is duration and ultimately safety of income streams. Bonds, because they pay current and more certain interest rates have a shorter duration than stocks. Should good stuff happen and rates continue a slow increase, we will receive a consistent income stream to help meet client objectives. Should bad stuff happen, bond prices would likely fall less than stock prices and provide a buffer of safety for risk reduction, short-term income, and a place to tap for buying more stocks at lower prices. In the uncertainty of the future, bonds still have a role to play for many investors.

Evergreen Conclusion

We have little ability to predict or control the timing of asset growth. Things well beyond our control will move asset pricing over time. However, we know long term investing is not about controlling or needing to predict but rather an understanding of the process, historical truths and meeting long term objectives.

2017 continues to be a solid year for markets and clients of all risk levels. Income and total returns continue to meet or exceed long term planning objectives and strengthen portfolios. We are pleased to see financial plans being fulfilled but are forced to remind everyone that good times will at some point take a temporary turn. Use this season to continue paying down debt, build savings, maintain your budget and stick with your long-term plan.

A client asked, what my biggest worry is the next 5 years? Our biggest worry going forward is a shift in investor sentiment from investing into speculating. We last saw this theme in 1997-1999 with tech stocks, which ended badly for many investors. I fully expect investors to forget about long term investing fundamentals at some point and start the process of greed and speculation. While we are in the early stages, we believe fighting speculative investing (trying to make outsized returns by investing in “hot” areas, often in unprofitable companies) may prove wise over the coming years. Remaining focused on the plan and objectives will be crucial.

We can gain an edge not by being smarter or ‘better’ at investing than the next person (or institution), but by changing our perspective. Instead of thinking we have some amazing ability to invest in ‘the next Apple (or Amazon, or Facebook, etc.)’, we can invest in high quality businesses that have proven they have strong and durable competitive advantages based on their track records. Instead of thinking we can spot a turnaround about to materialize, we can invest in businesses that are already incredibly profitable. Instead of pretending we have some secret that no one else knows to predict the next quarterly earnings report and gain from an earnings beat, we can invest for the long-run. – Sure Dividend Newsletter

By adhering to this logic we aim to minimize odds of suffering from irreversible losses, maximize odds of real sustainable gains and help control self defeating behavior that ultimately dooms investors to sub par returns long term. In short we aim to limit some of the speculative factor in our portfolios; but we know after 8 solid years in the market we are seeing a larger and larger presence of speculation driving the general index. We are working hard to combat the speculation and continue management with a disciplined framework to capture long term sustainable returns.

Evergreen Wealth remains committed to providing holistic investment solutions and financial planning. We remain honored to continue stewarding your assets and retirement journey.

Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.